Question

5. When comparing the ROAS and ROES, we concluded that the ROE > ROA as long as the ROA was greater than the average interest rate on the debt used to finance an investment. Please explain these finding and provide an example on these results. Refer to the fundamental rates of return identity when formulating your answer. 6. Provide numerical PV models in which you find an investment's IRR and NPVS using ROA-IRR and ROE-IRR, AE, maximum bid price, and the in- vestment's payback period. Defend your choice of a discount rate. 7. Explain how the "life of the investment" principle guarantees that all eco- nomic activity associated with an investment will be captured by its cash flow. 8. Most of the time, we don't identify discount rates in PV models as being either a ROE or a ROA. Instead we seem to prefer to identify the defender's ROA with the letter "r". Why do we tend to prefer ROA to ROE measures? describe a case when it would be important to evaluate the proj- Can you ects using the defender's ROE instead of its ROA?

Answer 1

Solution:

When we say that ROE>ROA only when ROA > Interest pain on the debt used for the investment we are talking about the financial leverage gain in here i.e. the business earned more profit than the interest paid on the money it borrowed and ultimately which increased the shareholder's equity and hence ROE.

We know ROA = EBIT / Net Operating Assets

Net Operating Assets = Total Assets - Non Interest bearing operating liabilities.

NOA -> Represents the total amount of capital raised from debt and equity.

Now For eg we say that the business's ROA is 15% and the interest rate on its debt is 8%, the net gain for the business on its debt capital is 7% i.e. more then what its paying on its debt. There a favorable spread of 7% which can be then multiplied times the total debt of the business to determine how much of its earnings before income tax is traceable to financial leverage gain.